14-1

CHAPTER 14 COST ALLOCATION, CUSTOMER-PROFITABILITY

ANALYSIS, AND SALES-VARIANCE ANALYSIS 14-1 Disagree. Cost accounting data plays a key role in many management planning and control decisions. The division president will be able to make better operating and strategy decisions by being involved in key decisions about cost pools and cost allocation bases. Such an understanding, for example, can help the division president evaluate the profitability of different customers. 14-2 Exhibit 14-1 outlines four purposes for allocating costs: 1. To provide information for economic decisions. 2. To motivate managers and other employees. 3. To justify costs or compute reimbursement amounts. 4. To measure income and assets. 14-3 Exhibit 14-2 lists four criteria used to guide cost allocation decisions: 1. Cause and effect. 2. Benefits received. 3. Fairness or equity. 4. Ability to bear. The cause-and-effect criterion and the benefits-received criterion are the dominant criteria when the purpose of the allocation is related to the economic decision purpose or the motivation purpose. 14-4 Disagree. In general, companies have three choices regarding the allocation of corporate costs to divisions: allocate all corporate costs, allocate some corporate costs (those “controllable”

by the divisions), and allocate none of the corporate costs. Which one of these is appropriate depends on several factors: the composition of corporate costs, the purpose of the costing exercise, and the time horizon, to name a few. For example, one can easily justify allocating all corporate costs when they are closely related to the running of the divisions and when the purpose of costing is, say, pricing products or motivating managers to consume corporate resources judiciously. 14-5 Disagree. If corporate costs allocated to a division can be reallocated to the indirect cost pools of the division on the basis of a logical cause-and-effect relationship, then it is in fact preferable to do so—this will result in fewer division indirect cost pools and a more cost-effective cost allocation system. This reallocation of allocated corporate costs should only be done if the allocation base used for each division indirect cost pool has the same cause-and-effect relationship with every cost in that indirect cost pool, including the reallocated corporate cost. Note that we observe such a situation with corporate human resource management (CHRM) costs in the case of CAI, Inc., described in the chapter—these allocated corporate costs are included in each division’s five indirect cost pools. (On the other hand, allocated corporate

treasury cost pools are kept in a separate cost pool and are allocated on a different cost-allocation base than the other division cost pools.)

14-2

14-6 Customer profitability analysis highlights to managers how individual customers differentially contribute to total profitability. It helps managers to see whether customers who contribute sizably to total profitability are receiving a comparable level of attention from the organization. 14-7 Companies that separately record (a) the list price and (b) the discount have sufficient information to subsequently examine the level of discounting by each individual customer and by each individual salesperson. 14-8 No. A customer-profitability profile highlights differences in current period's profitability across customers. Dropping customers should be the last resort. An unprofitable customer in one period may be highly profitable in subsequent future periods. Moreover, costs assigned to individual customers need not be purely variable with respect to short-run elimination of sales to those customers. Thus, when customers are dropped, costs assigned to those customers may not disappear in the short run. 14-9 Five categories in a customer cost hierarchy are identified in the chapter. The examples given relate to the Spring Distribution Company used in the chapter: Customer output-unit-level costs—costs of activities to sell each unit (case) to a customer.

An example is product-handling costs of each case sold. Customer batch-level costs—costs of activities that are related to a group of units (cases)

sold to a customer. Examples are costs incurred to process orders or to make deliveries. Customer-sustaining costs—costs of activities to support individual customers, regardless of

the number of units or batches of product delivered to the customer. Examples are costs of visits to customers or costs of displays at customer sites.

Distribution-channel costs—costs of activities related to a particular distribution channel rather than to each unit of product, each batch of product, or specific customers. An example is the salary of the manager of Spring’s retail distribution channel.

Corporate-sustaining costs—costs of activities that cannot be traced to individual customers or distribution channels. Examples are top management and general administration costs.

14-10 Using the levels approach introduced in Chapter 7, the sales-volume variance is a Level 2 variance. By sequencing through Level 3 (sales-mix and sales-quantity variances) and then Level 4 (market-size and market-share variances), managers can gain insight into the causes of a specific sales-volume variance caused by changes in the mix and quantity of the products sold as well as changes in market size and market share. 14-11 The total sales-mix variance arises from differences in the budgeted contribution margin of the actual and budgeted sales mix. The composite unit concept enables the effect of individual product changes to be summarized in a single intuitive number by using weights based on the mix of individual units in the actual and budgeted mix of products sold. 14-12 A favorable sales-quantity variance arises because the actual units of all products sold exceed the budgeted units of all products sold.

14-3

14-13 The sales-quantity variance can be decomposed into (a) a market-size variance (because the actual total market size in units is different from the budgeted market size in units), and (b) a market share variance (because the actual market share of a company is different from the budgeted market share of a company). Both variances use the budgeted average contribution margin per unit. 14-14 Some companies believe that reliable information on total market size is not available and therefore they choose not to compute market-size and market-share variances. 14-15 The direct materials efficiency variance is a Level 3 variance. Further insight into this variance can be gained by moving to a Level 4 analysis where the effect of mix and yield changes are quantified. The mix variance captures the effect of a change in the relative percentage use of each input relative to that budgeted. The yield variance captures the effect of a change in the total number of inputs required to obtain a given output relative to that budgeted. 14-16 (15-20 min.) Cost allocation in hospitals, alternative allocation criteria. 1. Direct costs = $2.40 Indirect costs ($11.52 – $2.40) = $9.12

Overhead rate = $9.12$2.40 = 380%

2. The answers here are less than clear-cut in some cases.

Overhead Cost Item Allocation Criteria Processing of paperwork for purchase Supplies room management fee Operating-room and patient-room handling costs Administrative hospital costs University teaching-related costs Malpractice insurance costs Cost of treating uninsured patients Profit component

Cause and effect Benefits received Cause and effect Benefits received Ability to bear Ability to bear or benefits received Ability to bear None. This is not a cost.

3. Assuming that Meltzer’s insurance company is responsible for paying the $4,800 bill, Meltzer probably can only express outrage at the amount of the bill. The point of this question is to note that even if Meltzer objects strongly to one or more overhead items, it is his insurance company that likely has the greater incentive to challenge the bill. Individual patients have very little power in the medical arena. In contrast, insurance companies have considerable power and may decide that certain costs are not reimbursable––for example, the costs of treating uninsured patients.

14-4

14-17 (15 min.) Cost allocation and motivation. Because corporate policy encourages line managers to seek legal counsel on pertinent issues from the Legal Department, any step in the direction of reducing costs of legal department services would be consistent with the corporate policy. Currently a user department is charged a standard fee of $400 per hour based on actual usage. It is possible that some managers may not be motivated to seek the legal counsel they need due to the high-allocated cost of the service. It is also possible that those managers whose departments are currently experiencing budgetary cost overruns may be disinclined to make use of the service; it would save them from the Legal Department’s cost allocation. However, it

could potentially result in much costlier penalties for Environ later if the corporation inadvertently engaged in some activities that violated one or more laws. It is quite likely that the line managers would seek legal counsel, whenever there were any pertinent legal issues, if the service were free. Making the service of the Legal Department free, however, might induce some managers to make excessive use of the service. To avoid any potential abuse, Environ may want to adjust the rate downward considerably, perhaps at a level lower than what it would cost if outside legal services were sought, but not eliminate it altogether. As long as the managers know that their respective departments would be charged for using the service, they would be disinclined to make use of it unnecessarily. However, they would be motivated to use it when necessary because it would be considered a “good value” if

the standard hourly rate was low enough.

14-5

14-18 (30 min.) Cost allocation to divisions. 1.

Hotel Restaurant Casino Rembrandt Revenue $16,425,000 $5,256,000 $12,340,000 $34,021,000 Direct costs 9,819,260 3,749,172 4,248,768 17,817,200 Segment margin $ 6,605,740 $1,506,828 $ 8,091,232 16,203,800 Fixed overhead costs 14,550,000 Income before taxes $ 1,653,800 Segment margin % 40.22% 28.67% 65.57% 2.

Hotel Restaurant Casino Rembrandt Direct costs $9819260 $3749172 $4248768 $17817200 Direct cost % 55.11% 21.04% 23.85% 100.00% Square footage 80,000 16,000 64,000 160,000 Square footage % 50.00% 10.00% 40.00% 100.00% Number of employees 200 50 250 500 Number of employees % 40.00% 10.00% 50.00% 100.00% A: Cost allocation based on direct costs:

Hotel Restaurant Casino Rembrandt Revenue $16,425,000 $ 5,256,000 $12,340,000 $34,021,000 Direct costs 9,819,260 3,749,172 4,248,768 17,817,200 Segment margin 6,605,740 1,506,828 8,091,232 16,203,800 Allocated fixed overhead costs 8,018,505 3,061,320 3,470,175 14,550,000 Segment pre-tax income $ (1,412,765) $ (1,554,492) $ 4,621,057 $ 1,653,800 Segment pre-tax income %

-8.60%

-29.58%

37.45%

B: Cost allocation based on floor space:

Hotel Restaurant Casino Rembrandt Allocated fixed overhead costs $7,275,000 $1,455,000 $5,820,000 $14,550,000 Segment pre-tax income $ (669,260) $ 51,828 $2,271,232 $ 1,653,800 Segment pre-tax income % -4.07% 0.99% 18.41% C: Cost allocation based on number of employees

Hotel Restaurant Casino Rembrandt Allocated fixed overhead costs $5,820,000 $1,455,000 $7,275,000 $14,550,000 Segment pre-tax income $ 785,740 $ 51,828 $ 816,232 $ 1,653,800 Segment pre-tax income % 4.78% 0.99% 6.61%

14-6

3. Requirement 2 shows the dramatic effect of choice of cost allocation base on segment pre-tax income percentages:

Pre-tax Income Percentage Allocation Base Hotel Restaurant Casino

Direct costs -8.60% -29.58% 37.45% Floor space -4.07 0.99 18.41 Number of employees 4.78 0.99 6.61

The decision context should guide (a) whether costs should be allocated, and (b) the

preferred cost allocation base. Decisions about, say, performance measurement, may be made on a combination of financial and nonfinancial measures. It may well be that Rembrandt may prefer to exclude allocated costs from the financial measures to reduce areas of dispute.

Where cost allocation is required, the cause-and-effect and benefits-received criteria are recommended in Chapter 14. The $14,550,000 is a fixed overhead cost. This means that on a short-run basis, the cause-and-effect criterion is not appropriate but Rembrandt could attempt to identify the cost drivers for these costs in the long run when these costs are likely to be more variable. Rembrandt should look at how the $14,550,000 cost benefits the three divisions. This will help guide the choice of an allocation base in the short run. 4. The analysis in requirement 2 should not guide the decision on whether to shut down any of the divisions. The overhead costs are fixed costs in the short run. It is not clear how these costs would be affected in the long run if Rembrandt shut down one of the divisions. Also, each division is not independent of the other two. A decision to shut down, say, the restaurant, likely would negatively affect the attendance at the casino and possibly the hotel. Rembrandt should examine the future revenue and future cost implications of different resource investments in the three divisions. This is a future-oriented exercise, whereas the analysis in requirement 2 is an analysis of past costs.

14-7

14-19 (25 min.) Cost allocation to divisions. Percentages for various allocation bases (old and new):

Pulp Paper Fibers Total (1) Division margin percentages $2,400,000; $7,100,000; $9,500,000 $19,000,000

12.63157%

37.36843% 50.0% 100.0%

(2) Share of employees $350; 250; 400 1,000 35.0 25.0 40.0 100.0 (3) Share of floor space 35,000; 24,000; 66,000 125,000 28.0 19.2 52.8 100.0 (4) Share of total division administrative costs $2,000,000; $1,800,000; $3,200,000 $7,000,000 28.57142 25.71428 45.71428 100.0 1. Pulp Paper Fibers Total (5) Division margin $2,400,000 $ 7,100,000 $ 9,500,000 $19,000,000 (6) Corporate overhead allocated on segment margins = (1) $9,000,000 1,136,842 3,363,158 4,500,000 9,000,000 (7) Operating margin with division-margin-based allocation = (5) – (6) $1,263,158 $ 3,736,842 $ 5,000,000 $10,000,000 (8) Revenues $8,500,000 $17,500,000 $24,000,000 $50,000,000 Operating margin as a percentage of revenues 14.9% 21.3% 20.8% 20.0% 2.

Pulp Paper Fibers Total (5) Division margin $2,400,000 $ 7,100,000 $ 9,500,000 $19,000,000 HRM costs (alloc. base: no. of employees) = (2) $1,800,000 630 ,000 450,000 720,000 1,800,000 Facility costs (alloc. base: floor space) = (3) $2,700,000 756,000 518,400 1,425,600 2,700,000 Corp. admin (alloc. base: div. admin costs) = (4) $4,500,000 1,285,714 1,157,143 2,057,143 4,500,000 Corp. overhead allocated to each division 2,671,714 2,125,543 4,202,743 9,000,000 Operating margin with cause-and-effect allocation $ (271,714) $ 4,974,457 $ 5,297,257 $10,000,000 (8) Revenues $8,500,000 $17,500,000 $24,000,000 $50,000,000 Operating margin as a percentage of revenues -3.2% 28.4% 22.1% 20.0 %

14-8

3. When corporate overhead is allocated to the divisions on the basis of division margins (requirement 1), each division is profitable (has positive operating margin) and the Paper division is the most profitable (has the highest operating margin percentage) by a slim margin, while the Pulp division is the least profitable. When Bardem’s suggested bases are used to

allocate the different types of corporate overhead costs (requirement 2), we see that, in fact, the Pulp division is not profitable (it has a negative operating margin). Paper continues to be the most profitable and, in fact, it is significantly more profitable than the Fibers division. If division performance is linked to operating margin percentages, Pulp will resist this new way of allocating corporate costs, which causes its operating margin of nearly 15% (in the old scheme) to be transformed into a -3.2% operating margin. The new cost allocation methodology reveals that, if the allocation bases are reasonable, the Pulp division consumes a greater share of corporate resources than its share of segment margins would indicate. Pulp generates 12.6% of the segment margins, but consumes almost 29.7% ($2,671,714 $9,000,000) of corporate overhead resources. Paper will welcome the change—its operating margin percentage rises the most, and Fiber’s operating margin percentage remains practically

the same. Note that in the old scheme, Paper was being penalized for its efficiency (smallest share of administrative costs), by being allocated a larger share of corporate overhead. In the new scheme, its efficiency in terms of administrative costs, employees, and square footage is being recognized. 4. The new approach is preferable because it is based on cause-and-effect relationships between costs and their respective cost drivers in the long run. Human resource management costs are allocated using the number of employees in each division because the costs for recruitment, training, etc., are mostly related to the number of employees in each division. Facility costs are mostly incurred on the basis of space occupied by each division. Corporate administration costs are allocated on the basis of divisional administrative costs because these costs are incurred to provide support to divisional administrations. To overcome objections from the divisions, Bardem may initially choose not to allocate corporate overhead to divisions when evaluating performance. He could start by sharing the results with the divisions, and giving them—particularly the Pulp division—adequate time to figure out how to reduce their share of cost drivers. He should also develop benchmarks by comparing the consumption of corporate resources to competitors and other industry standards.

14-9

14-20 (30 min.) Customer profitability, customer cost hierarchy. 1. All amounts in thousands of U.S. dollars Wholesale Retail North America South America Big Sam World Wholesaler Wholesaler Stereo Market Revenues at list prices $420,000 $580,000 $130,000 $100,000 Price discounts 30,000 40,000 7,000 500 Revenues (at actual prices) 390,000 540,000 123,000 99,500 Cost of goods sold 325,000 455,000 118,000 90,000 Gross margin 65,000 85,000 5,000 9,500 Customer-level operating costs Delivery 450 650 200 125 Order processing 800 1,000 200 130 Sales visit 5,600 5,500 2,300 1,350 Total cust.-level optg.costs 6,850 7,150 2,700 1,605 Customer-level operating income $ 58,150 $ 77,850 $ 2,300 $ 7,895

14-10

2. Customer Distribution Channels (all amounts in $000s) Wholesale Customers Retail Customers Total Total North America South America Total Big Sam World (all customers) Wholesale Wholesaler Wholesaler Retail Stereo Market (1) = (2) + (5) (2) = (3) + (4) (3) (4) (5) = (6) + (7) (6) (7) Revenues (at actual prices) $1,152,500 $930,000 $390,000 $540,000 $222,500 $123,000 $99,500 Customer-level costs 1,006,305 794,000 331,850 a 462,150 a 212,305 120,700 a 91,605 a Customer-level operating income 146,195 136,000 $ 58,150 $ 77,850 10,195 $ 2,300 $ 7,895 Distribution-channel costs 43,000 35,000 8,000 Distribution-channel-level oper. income 103,195 $101,000 $ 2,195 Corporate-sustaining costs 60,000 Operating income $ 43,195 aCost of goods sold + Total customer-level operating costs from Requirement 1 3. If corporate costs are allocated to the channels, the retail channel will show an operating loss of $9,805,000 ($2,195,000 – $12,000,000), and the wholesale channel will show an operating profit of only $53,000,000 ($101,000,000 – $48,000,000). The overall operating profit, of course, is still $43,195,000, as in requirement 2. There is, however, no cause-and-effect or benefits-received relationship between corporate costs and any allocation base, i.e., the allocation of $48,000,000 to the wholesale channel and of $12,000,000 to the retail channel is arbitrary and not useful for decision-making. Therefore, the management of Ramish Electronics should not base any performance evaluations or investment/disinvestment decisions based on these channel-level operating income numbers. They may want to take corporate costs into account, however, when making pricing decisions.

14-11

14-21 (2030 min.) Customer profitability, service company. 1. Avery Okie Wizard Grainger Duran Revenues $260,000 $200,000 $322,000 $122,000 $212,000 Technician and equipment cost 182,000 175,000 225,000 107,000 178,000 Gross margin 78,000 25,000 97,000 15,000 34,000 Service call handling ($75 150; 240; 40; 120; 180) 11,250 18,000 3,000 9,000 13,500 Web-based parts ordering ($80 120; 210; 60; 150; 150) 9,600 16,800 4,800 12,000 12,000 Billing/Collection ($50 30; 90; 90; 60; 120) 1,500 4,500 4,500 3,000 6,000 Database maintenance ($10 150; 240; 40; 120; 180) 1,500 2,400 400 1,200 1,800 Customer-level operating income $ 54,150 $ (16,700) $ 84,300 $(10,200) $ 700 2. Customers Ranked on Customer-Level Operating Income

Cumulative Customer-Level Operating Income Customer-Level Customer-Level Cumulative as a % of Total

Operating Customer Operating Income Customer-Level Customer-Level Customer Income Revenue as a % of Revenue Operating Income Operating Income

Code (1) (2) (3) = (1) (2) (4) (5) = (4) $112,250 Wizard $ 84,300 $ 322,000 26.18% $84,300 75% Avery 54,150 260,000 20.83% 138,450 123% Duran 700 212,000 0.33% 139,150 124% Grainger (10,200) 122,000 -8.36% 128,950 115% Okie (16,700) 200,000 -8.35% 112,250 100% $112,250 $1,116,000

14-12

The above table and graph present the summary results. Wizard, the most profitable customer, provides 75% of total operating income. The three best customers provide 124% of IS’s operating income, and the other two, by incurring losses for IS, erode the extra 24% of operating income down to IS’s operating income. 3. The options that Instant Service should consider include:

a. Increase the attention paid to Wizard and Avery. These are “key customers,” and every effort has to be made to ensure they retain IS. IS may well want to suggest a minor price reduction to signal how important it is in their view to provide a cost-effective service to these customers.

b. Seek ways of reducing the costs or increasing the revenues of the problem accounts––

Okie and Grainger. For example, are the copying machines at those customer locations outdated and in need of repair? If yes, an increased charge may be appropriate. Can IS provide better on-site guidelines to users about ways to reduce breakdowns?

c. As a last resort, IS may want to consider dropping particular accounts. For example, if Grainger (or Okie) will not agree to a fee increase but has machines continually breaking down, IS may well decide that it is time not to bid on any more work for that customer. But care must then be taken to otherwise use or get rid of the excess fixed capacity created by “firing” unprofitable customers.

Customer-Level Operating Income

$84,300

$54,150

$700

$(10,200)

$(16,700)

-$40,000

-$20,000

$0

$20,000

$40,000

$60,000

$80,000

$100,000

Customers

Cus

tom

er-L

evel

Ope

ratin

g In

com

e

Grainger

Avery

Okie

Duran

Wizard

14-13

14-22 (2025 min.) Customer profitability, distribution. 1. The activity-based costing for each customer is:

Charleston Pharmacy

Chapel Hill Pharmacy

1. Order processing, $40 × 12; $40 × 10 $ 480 $ 400 2. Line-item ordering, $3 × (12 × 10;10 × 18) 360 540 3. Store deliveries, $50 × 6; $50 ×10 300 500 4. Carton deliveries, $1 × (6 × 24; 10 × 20) 144 200 5. Shelf-stocking, $16 × (6 × 0; 10 × 0.5) 0 80 Operating costs $1,284 $1,720

The operating income of each customer is:

Charleston Pharmacy

Chapel Hill Pharmacy

Revenues, $2,400 × 6; $1,800 × 10 $14,400 $18,000 Cost of goods sold, $2,100 × 6; $1,650 × 10 12,600 16,500 Gross margin 1,800 1,500 Operating costs 1,284 1,720 Operating income $ 516 $ (220)

Chapel Hill Pharmacy has a lower gross margin percentage than Charleston (8.33% vs. 12.50%) and consumes more resources to obtain this lower margin. 2. Ways Figure Four could use this information include: a. Pay increased attention to the top 20% of the customers. This could entail asking them for

ways to improve service. Alternatively, you may want to highlight to your own personnel the importance of these customers; e.g., it could entail stressing to delivery people the importance of never missing delivery dates for these customers.

b. Work out ways internally at Figure Four to reduce the rate per cost driver; e.g., reduce the cost per order by having better order placement linkages with customers. This cost reduction by Figure Four will improve the profitability of all customers.

c. Work with customers so that their behavior reduces the total “system-wide” costs. At a minimum, this approach could entail having customers make fewer orders and fewer line items. This latter point is controversial with students; the rationale is that a reduction in the number of line items (diversity of products) carried by Ma and Pa stores may reduce the diversity of products Figure Four carries.

14-14

There are several options here: Simple verbal persuasion by showing customers cost drivers at Figure Four. Explicitly pricing out activities like cartons delivered and shelf-stocking so that

customers pay for the costs they cause. Restricting options available to certain customers, e.g., customers with low revenues

could be restricted to one free delivery per week.

An even more extreme example is working with customers so that deliveries are easier to make and shelf-stocking can be done faster. d. Offer salespeople bonuses based on the operating income of each customer rather than

the gross margin of each customer. Some students will argue that the bottom 40% of the customers should be dropped. This action should be only a last resort after all other avenues have been explored. Moreover, an unprofitable customer today may well be a profitable customer tomorrow, and it is myopic to focus on only a 1-month customer-profitability analysis to classify a customer as unprofitable. 14-23 (30–40 min.) Variance analysis, multiple products.

1. Sales-volume

variance =

unitsin quantity

sales Actual

unitsin quantity sales Budgeted

per ticketmargin oncontributi Budgeted

Lower-tier tickets = (3,300 – 4,000) $20 = $14,000 U Upper-tier tickets = (7,700 – 6,000) $ 5 = 8,500 F All tickets $ 5,500 U

2. unitper margin on contributiaverage Budgeted =

000,10$5) (6,000 $20) 000,4(

= 10,000

$30,000 000,80$ =

000,10000,110$

= $11 per unit (seat sold) Sales-mix percentages:

Budgeted Actual

Lower-tier 000,10000,4 = 0.40

000,11300,3 = 0.30

Upper-tier 000,10000,6 = 0.60

000,11700,7 = 0.70

14-15

Solution Exhibit 14-23 presents the sales-volume, sales-quantity, and sales-mix variances for lower-tier tickets, upper-tier tickets, and in total for Detroit Penguins in 2007. The sales-quantity variances can also be computed as:

Sales-quantityvariance =

sold ticketsall of

units Budgeted

sold ticketsall of

units Actual

percentagemix-sales

Budgeted

per ticketmargin cont.

Budgeted

The sales-quantity variances are: Lower-tier tickets = (11,000 – 10,000) × 0.40 × $20 = $ 8,000 F Upper-tier tickets = (11,000 – 10,000) × 0.60 × $ 5 = 3,000 F All tickets $11,000 F The sales-mix variance can also be computed as: Sales-mixvariance =

sold ticketsall of

units Actual×

Actual Budgeted Budgetedcontribution marginsales-mix sales-mix

per ticketpercentage percentage

The sales-mix variances are Lower-tier tickets = 11,000 × (0.30 – 0.40) × $20 = $22,000 U Upper-tier tickets = 11,000 × (0.70 – 0.60) × $ 5 = 5,500 F All tickets $16,500 U 3. The Detroit Penguins increased average attendance by 10% per game. However, there was a sizable shift from lower-tier seats (budgeted contribution margin of $20 per seat) to the upper-tier seats (budgeted contribution margin of $5 per seat). The net result: the actual contribution margin was $5,500 below the budgeted contribution margin.

14-16

SOLUTION EXHIBIT 14-23 Columnar Presentation of Sales-Volume, Sales-Quantity and Sales-Mix Variances for Detroit Penguins

Flexible Budget: Actual Units of

All Products Sold × Actual Sales Mix

× Budgeted Contribution

Margin per Unit (1)

Actual Units of

All Products Sold × Budgeted Sales Mix

× Budgeted Contribution Margin

per Unit (2)

Static Budget: Budgeted Units of All Products Sold

× Budgeted Sales Mix × Budgeted

Contribution Margin per Unit

(3) Panel A: Lower-tier

(11,000 × 0.30a) × $20

3,300 × $20

(11,000 × 0.40b) × $20

4,400 × $20

(10,000 × 0.40b) × $20

4,000 × $20 $66,000 $88,000 $80,000 $22,000U $8,000 F Sales-mix variance Sales-quantity variance $14,000 U Sales-volume variance Panel B: Upper-tier

(11,000 × 0.70c) × $5

7,700 × $5

(11,000 × 0.60d) × $5

6,600 × $5

(10,000 × 0.60d) × $5

6,000 × $5 $38,500 $33,000 $30,000 $5,500 F $3,000 F Sales-mix variance Sales-quantity variance $8,500 F Sales-volume variance Panel C: All Tickets (Sum of Lower-tier and Upper-tier tickets)

$104,500e $121,000f $110,000g $16,500 U $11,000 F Total sales-mix variance Total sales-quantity variance $5,500 U Total sales-volume variance

F = favorable effect on operating income; U = unfavorable effect on operating income. Actual Sales Mix:

aLower-tier = 3,300 ÷ 11,000 = 30% cUpper-tier = 7,700 ÷ 11,000 = 70% e$66,000 + $38,500 = $104,500

Budgeted Sales Mix: bLower-tier = 4,000 ÷ 10,000 = 40% dUpper-tier = 6,000 ÷ 10,000 = 60% f $88,000 + $33,000 = $121,000 g $80,000 + $30,000 = $110,000

14-17

14-24 (30 min.) Variance analysis, working backward. 1. and 2. Solution Exhibit 14-24 presents the sales-volume, sales-quantity, and sales-mix variances for the Plain and Chic wine glasses and in total for Jinwa Corporation in June 2006. The steps to fill in the numbers in Solution Exhibit 14-24 follow: Step 1 Consider the static budget column (Column 3): Static budget total contribution margin $5,600 Budgeted units of all glasses to be sold 2,000 Budgeted contribution margin per unit of Plain $2 Budgeted contribution margin per unit of Chic $6 Suppose that the budgeted sales-mix percentage of Plain is y. Then the budgeted sales-mix percentage of Chic is (1 – y). Therefore,

(2,000y $2) + (2,000 (1 – y) $6) = $5,600 $4000y + $12,000 – $12,000y = $5,600 $8,000y = $6,400 y = 0.8 or 80% 1 – y = 20%

Jinwa’s budgeted sales mix is 80% of Plain and 20% of Chic. We can then fill in all the numbers in Column 3. Step 2 Next, consider Column 2 of Solution Exhibit 14-24. The total of Column 2 in Panel C is $4,200 (the static budget total contribution margin of $5,600 – the total sales-quantity variance of $1,400 U which was given in the problem). We need to find the actual units sold of all glasses, which we denote by q. From Column 2, we know that (q 0.8 $2) + (q 0.2 $6) = $4,200 $1.6q + $1.2q = $4,200 $2.8q = $4,200 q = 1,500 units So, the total quantity of all glasses sold is 1,500 units. This computation allows us to fill in all the numbers in Column 2.

14-18

Step 3 Next, consider Column 1 of Solution Exhibit 14-24. We know actual units sold of all glasses (1,500 units), the actual sales-mix percentage (given in the problem information as Plain, 60%; Chic, 40%), and the budgeted unit contribution margin of each product (Plain, $2; Chic, $6). We can therefore determine all the numbers in Column 1. Solution Exhibit 14-24 displays the following sales-quantity, sales-mix, and sales-volume variances:

Sales-Volume Variance Plain $1,400 U Chic 1,200 F All Glasses $ 200 U

Sales-Mix Variances Sales-Quantity Variances

Plain $ 600 U Plain $ 800 U Chic 1,800 F Chic 600 U All Glasses $1,200 F All Glasses $1,400 U

3. Jinwa Corporation shows an unfavorable sales-quantity variance because it sold fewer wine glasses in total than was budgeted. This unfavorable sales-quantity variance is partially offset by a favorable sales-mix variance because the actual mix of wine glasses sold has shifted in favor of the higher contribution margin Chic wine glasses. The problem illustrates how failure to achieve the budgeted market penetration can have negative effects on operating income.

14-19

SOLUTION EXHIBIT 14-24 Columnar Presentation of Sales-Volume, Sales-Quantity and Sales-Mix Variances for Jinwa Corporation

Flexible Budget: Actual Units

of All Glasses Sold Actual Sales Mix

Budgeted Contribution

Margin per Unit

Actual Units

of All Glasses Sold Budgeted Sales Mix

Budgeted Contribution

Margin per Unit

Static Budget: Budgeted Units

of All Glasses Sold Budgeted Sales Mix

Budgeted Contribution

Margin per Unit

Panel A: Plain

(1,500 0.6) $2 900 $2

(1,500 0.8) $2 1,200 $2

(2,000 0.8) $2 1,600 $2

$1,800 $2,400 $3,200 $600 U $800 U Sales-mix variance Sales-quantity variance $1,400 U Sales-volume variance Panel B: Chic

(1,500 0.4) $6

600 $6

(1,500 0.2) $6

300 $6

(2,000 0.2) $6

400 $6 $3,600 $1,800 $2,400 $1,800 F $600 U Sales-mix variance Sales-quantity variance $1,200 F Sales-volume variance Panel C: All Glasses

$5,400 $4,200 $5,600 $1,200 F $1,400 U Total sales-mix variance Total sales-quantity variance $200 U Total sales-volume variance

F = favorable effect on operating income; U = unfavorable effect on operating income.

14-20

14-25 (60 min.) Variance analysis, multiple products. 1. Budget for 2006 Variable Contrib. Selling Cost Margin Units Sales Contribution Price per Unit per Unit Sold Mix Margin (1) (2) (3) = (1) – (2) (4) (5) (6) = (3) × (4) Kola $6.00 $4.00 $2.00 400,000 16% $ 800,000 Limor 4.00 2.80 1.20 600,000 24 720,000 Orlem 7.00 4.50 2.50 1,500,000 60 3,750,000 Total 2,500,000 100% $5,270,000 Actual for 2006 Variable Contrib. Selling Cost Margin Units Sales Contribution Price per Unit per Unit Sold Mix Margin (1) (2) (3) = (1) – (2) (4) (5) (6) = (3) × (4) Kola $6.20 $4.50 $1.70 480,000 16% $ 816,000 Limor 4.25 2.75 1.50 900,000 30 1,350,000 Orlem 6.80 4.60 2.20 1,620,000 54 3,564,000 Total 3,000,000 100% $5,730,000 Solution Exhibit 14-25 presents the sales-volume, sales-quantity, and sales-mix variances for each product and in total for 2006.

Sales-volumevariance

Actual Budgetedquantity of quantity ofunits sold units sold

Budgetedcontribution margin

per unit

Kola = ( 480,000 – 400,000) × $2.00 = $160,000 F Limor = ( 900,000 – 600,000) × $1.20 = 360,000 F Orlem = (1,620,000 – 1,500,000) × $2.50 = 300,000 F Total $820,000 F

Sales-quantityvariance

Actual units Budgeted unitsof all products of all products

sold sold

Budgetedsales-mixpercentage

Budgeted

contribution marginper unit

Kola = (3,000,000 – 2,500,000) × 0.16 × $2.00 = $ 160,000 F Limor = (3,000,000 – 2,500,000) × 0.24 × $1.20 = 144,000 F Orlem = (3,000,000 – 2,500,000) × 0.60 × $2.50 = 750,000 F Total $1,054,000 F

14-21

Actual units Actual Budgeted Budgeted = of all products × sales-mix – sales-mix × contrib. margin sold percentage percentage per unit Kola = 3,000,000 × (0.16 – 0.16) × $2.00 = $ 0 Limor = 3,000,000 × (0.30– 0.24) × $1.20 = 216,000 F Orlem = 3,000,000 × (0.54 – 0.60) × $2.50 = 450,000 U Total $234,000 U 2. The breakdown of the favorable sales-volume variance of $820,000 shows that the biggest contributor is the 500,000 unit increase in sales resulting in a favorable sales-quantity variance of $1,054,000. There is a partially offsetting unfavorable sales-mix variance of $234,000 in contribution margin. SOLUTION EXHIBIT 14-25

Sales-Mix and Sales-Quantity Variance Analysis of Soda King for 2006

Flexible Budget: Static Budget: Actual Units of Actual Units of Budgeted Units of All Products Sold All Products Sold All Products Sold Actual Sales Mix Budgeted Sales Mix Budgeted Sales Mix Budgeted Contribution Budgeted Contribution Budgeted Contribution Margin Per Unit Margin Per Unit Margin Per Unit Kola 3,000,000 0.16 $2 = $ 960,000 3,000,000 0.16 $2 = $ 960,000 2,500,000 0.16 $2 = $ 800,000 Limor 3,000,000 0.30 $1.20 = 1,080,000 3,000,000 0.24 $1.20 = 864,000 2,500,000 0.24 $1.20 = 720,000 Orlem 3,000,000 0.54 $2.50 = 4,050,000 3,000,000 0.60 $2.50 = 4,500,000 2,500,000 0.60 $2.50 = 3,750,000 $6,090,000 $6,324,000 $5,270,000 $234,000 U $1,054,000 F Sales-mix variance Sales-quantity variance $820,000 F Sales-volume variance F = favorable effect on operating income; U= unfavorable effect on operating income

Sales-mix variance

14-22

14-26 (20 min.) Market-share and market-size variances (continuation of 14-25). Actual Budgeted Western region 24 million 25 million Soda King 3 million 2.5 million Market share 12.5% 10% Average budgeted contribution margin per unit = $2.108 ($5,270,000 ÷ 2,500,000) Solution Exhibit 14-26 presents the sales-quantity variance, market-size variance, and market-share variance for 2006. Actual Actual Budgeted Budgeted contribution Market-share = market size × market – market × margin per composite variance in units share share unit for budgeted mix = 24,000,000 × (0.125 – 0.10) × $2.108 = 24,000,000 × .025 × $2.108 = $1,264,800 F Actual Budgeted Budgeted Budgeted contribution Market-size = market size – market size × market × margin per composite variance in units in units share unit for budgeted mix

= (24,000,000 – 25,000,000) × 0.10 × $2.108 = – 1,000,000 × 0.10 × $2.108 = 210,800 U

The market share variance is favorable because the actual 12.5% market share was higher than the budgeted 10% market share. The market size variance is unfavorable because the market size decreased 4% [(25,000,000 – 24,000,000) ÷ 25,000,000]. While the overall total market size declined (from 25 million to 24 million), the increase in market share meant a favorable sales-quantity variance.

Sales-Quantity Variance $1,054,000 F

Market-share variance Market-size variance $1,264,800 F $210,800 U

14-23

SOLUTION EXHIBIT 14-26 Market-Share and Market-Size Variance Analysis of Soda King for 2006 Static Budget: Actual Market Size Actual Market Size Budgeted Market Size Actual Market Share Budgeted Market Share Budgeted Market Share Budgeted Average Budgeted Average Budgeted Average Contribution Margin Contribution Margin Contribution Margin Per Unit Per Unit Per Unit 24,000,000 0.125a $2.108b 24,000,000 0.10c $2.108 b 25,000,000 0.10c $2.108b $6,324,000 $5,059,200 $5,270,000 $1,264,800 F $210,800 U

Market-share variance Market-size variance

$1,054,000 F

Sales-quantity variance

F = favorable effect on operating income; U = unfavorable effect on operating income aActual market share: 3,000,000 units ÷ 24,000,000 units = 0.125, or 12.5% bBudgeted average contribution margin per unit $5,270,000 ÷ 2,500,000 units = $2.108 per unit cBudgeted market share: 2,500,000 units ÷ 25,000,000 units = 0.10, or 10%

14-24

14-27 (40 min.) Allocation of corporate costs to divisions. 1. The purposes for allocating central corporate costs to each division include the following (students may pick and discuss any two): a. To provide information for economic decisions. Allocations can signal to division

managers that decisions to expand (contract) activities will likely require increases (decreases) in corporate costs that should be considered in the initial decision about expansion (contraction). When top management is allocating resources to divisions, analysis of relative division profitability should consider differential use of corporate services by divisions. Some allocation schemes can encourage the use of central services that would otherwise be underutilized. A common rationale related to this purpose is “to

remind profit center managers that central corporate costs exist and that division earnings must be adequate to cover some share of those costs.”

b. Motivation. Allocations create incentives for division managers to control costs; for example, by reducing the number of employees at a division, a manager will save direct labor costs as well as central personnel and payroll costs allocated on the basis of number of employees. Allocation also creates incentives for division managers to monitor the effectiveness and efficiency with which central corporate costs are spent.

c. Cost justification or reimbursement. Some lines of business of Richfield Oil may be regulated with cost data used in determining “fair prices”; allocations of central corporate

costs will result in higher prices being set by a regulator. d. Income measurement for external parties. Richfield Oil may include allocations of

central corporate costs in its external line-of-business reporting.

Instructors may wish to discuss the “Surveys of Company Practice” evidence from the United States, Australia, Sweden, and the United Kingdom in Chapter 14. 2.

Oil & Gas Upstream

Oil & Gas Downstream

Chemical Products

Copper Mining Total

Revenues $8,000 $16,000 $4,800 $3,200 $32,000 Percentage of revenues $8,000; $16,000; $4,800; $3,200 $32,000 25% 50% 15% 10% 100%

(Dollar amounts in millions) Oil & Gas Upstream

Oil & Gas Downstream

Chemical Products

Copper Mining Total

Revenues $8,000 $16,000 $4,800 $3,200 $32,000 Operating costs 3,000 15,000 3,800 3,500 25,300 Operating income 5,000 1,000 1,000 (300) 6,700 Corp. costs allocated on revenues (% of revs $3,228) 807 1,614 484 323 3,228 Division operating income $4,193 $ (614) $ 516 $ (623) $ 3,472

14-25

3. First, calculate the share of each allocation base for each of the four corporate cost pools:

Oil & Gas Upstream

Oil & Gas Downstream

Chemical Products

Copper Mining Total

Identifiable assets $14,000 $6,000 $3,000 $2,000 $25,000 (1)Percentage of total identifiable assets $14,000; $6,000; $3,000; $2,000 $25,000 56% 24% 12% 8% 100% Division revenues $8,000 $16,000 $4,800 $3,200 $32,000 (2) Percentage of total division revenues $8,000; $16,000; $4,800; $3,200 $32,000 25% 50% 15% 10% 100% Positive operating income $5,000 $1,000 $1,000 NONE $7,000 (3) Percentage of total positive operating income $5,000; $1,000; $1,000; 0 $7,000 71.4% 14.3% 14.3% 0% 100% Number of employees 9,000 12,000 6,000 3,000 30,000 (4) Percentage of total employees 9,000; 12,000; 6,000; 3,000 30,000 30% 40% 20% 10% 100%

Using these allocation percentages and the allocation bases suggested by Rhodes, we can allocate the $3,228 M of corporate costs as shown below. Note that the costs in Cost Pool 2 total $800 M ($150 + $110 + $200 + $140 + $200).

(Dollar amounts in millions) Oil & Gas Upstream

Oil & Gas Downstream

Chemical Products

Copper Mining Total

Revenues $8,000.00 $16,000.00 $4,800.00 $3,200.00 $32,000 Operating Costs 3,000.00 15,000.00 3,800.00 3,500.00 25,300 Operating Income 5,000.00 1,000.00 1,000.00 (300.00) 6,700 Cost Pool 1 Allocation ((1) $2,000) 1,120.00 480.00 240.00 160.00 2,000 Cost Pool 2 Allocation ((2) $800) 200.00 400.00 120.00 80.00 800 Cost Pool 3 Allocation ((3) $203) 145.00 29.00 29.00 0.00 203 Cost Pool 4 Allocation ((4) $225) 67.50 90.00 45.00 22.50 225 Division Income $3,467.50 $ 1.00 $ 566.00 $ (562.50) $ 3,472

4. The table below compares the reported income of each division under the original revenue-based allocation scheme and the new 4-pool-based allocation scheme. Oil & Gas Upstream seems 17% less profitable than before ($3,467.5 $4,193 = 83%), and may resist the new allocation, but each of the other divisions seem more profitable (or less loss-making) than before and they will probably welcome it. In this setting, corporate costs are relatively large (about 13% of total operating costs), and division incomes are sensitive to the corporate cost allocation method.

(Dollar amounts in millions) Oil & Gas Upstream

Oil & Gas Downstream

Chemical Products

Copper Mining Total

Operating Income (before corp. cost allocation) $5,000.00 $1,000.00 $1,000.00 $(300.00) $6,700 Division income under revenue-based allocation of corporate costs $4,193.00 $ (614.00) $ 516.00 $(623.00) $3,472 Division income under 4-cost-pool allocation of corporate costs $3,467.50 $ 1.00 $ 566.00 $(562.50) $3,472 Strengths of Rhodes’ proposal relative to existing single-cost pool method:

14-26

a. Better able to capture cause-and-effect relationships. Interest on debt is more likely

caused by the financing of assets than by revenues. Personnel and payroll costs are more likely caused by the number of employees than by revenues.

b. Relatively simple. No extra information need be collected beyond that already available.

(Some students will list the extra costs of Rhodes' proposal as a weakness. However, for a company with $30 billion in revenues, those extra costs are minimal.)

Weaknesses of Rhodes’ proposal relative to existing single-cost pool method: a. May promote dysfunctional decision making. May encourage division managers to lease

or rent assets rather than to purchase assets, even where it is economical for Richfield Oil to purchase them. This off-balance sheet financing will reduce the “identifiable assets” of the division and thus will reduce the interest on debt costs allocated to the division. (Richfield Oil could counteract this problem by incorporating leased and rented assets in the "identifiable assets" base.)

Note: Some students criticized Rhodes’ proposal, even though agreeing that it is preferable to the existing single-cost pool method. These criticisms include: a. The proposal does not adequately capture cause-and-effect relationships for the legal and

research and development cost pools. For these cost pools, specific identification of individual projects with an individual division can better capture cause-and-effect relationships.

b. The proposal may give rise to disputes over the definition and valuation of “identifiable

assets.” c. The use of actual rather than budgeted amounts in the allocation bases creates

interdependencies between divisions. Moreover, use of actual amounts means that division managers do not know cost allocation consequences of their decisions until the end of each reporting period.

d. A separate allocation of fixed and variable costs would result in more refined cost

allocations. e. It is questionable that 100% of central corporate costs should be allocated. Many students

argue that public affairs should not be allocated to any division, based on the notion that division managers may not control many of the individual expenditures in this cost pool.

14-27

14-28 (25–30 min.) Allocation of central corporate costs to divisions. Print Book Total Multimedia Broadcasting Media Publishing Interest on debt $ 10,000,000 $ 3,500,000 $ 6,500,000 $ -0- $ -0- Human resource management (1,000: 3,000: 2,500: 1,500) 150,000,000 18,750,000 56,250,000 46,875,000 28,125,000 Corporate adminis- tration (150: 400: 250: 200) 50,000,000 7,500,000 20,000,000 12,500,000 10,000,000 Research and development (40%, 30%, 0%, 30%) 100,000,000 40,000,000 30,000,000 -0- 30,000,000 Advertising (1,400: 4,500: 2,500: 1,600) 200,000,000 28,000,000 90,000,000 50,000,000 32,000,000 Total $510,000,000 $ 97,750,000 $202,750,000 $109,375,000 $100,125,000

14-28

14-29 (30–40 min.) Customer-profitability analysis, customer-cost hierarchy. 1.

Arvin Madison Suitors LuxTux No. of suits sold 52 380; 30 660; 220 40; 280 30 19,760 19,800 8,800 8,400 Revenues (at list) (No. of suits sold $250) $4,940,000 $4,950,000 $2,200,000 $2,100,000 Price discount ($250 – $190) 19,760; ($250 – $210) 19,800; ($250 – $220) 8,800; ($250 – $230) 8,400 1,185,600 792,000 264,000 168,000 Revenues (at actual prices) 3,754,400 4,158,000 1,936,000 1,932,000 Cost of goods sold (No. of suits sold $150) 2,964,000 2,970,000 1,320,000 1,260,000 Gross Margin 790,400 1,188,000 616,000 672,000

Customer-level operating costs Order processing costs $250 52; 30; 220; 280 13,000 7,500 55,000 70,000 Sales visits’ costs $1,150 12; 15; 35; 20 13,800 17,250 40,250 23,000 Regular deliveries’ costs $300 45; 18; 150; 245 13,500 5,400 45,000 73,500 Rushed deliveries’ costs $8.50 7; 12; 70; 35 5,950 10,200 59,500 29,750 Total customer-level operating costs 46,250 40,350 199,750 196,250 Customer-level operating income $ 744,150 $1,147,650 $ 416,250 $ 475,750 Operating income per suit (Customer-level operating income Suits sold) $37.66 $57.96 $47.30 $56.64 2. Key challenges facing Sims are:

a. Reduce level of price discounting, especially to Arvin. b. Reduce level of customer-level costs, especially those of Suitors and LuxTux. These

retail customers’ customer-level operating costs are each about 10% of actual revenues vs. about 1% of actual revenues for each of the wholesale customers.

The ABC cost system highlights areas where the Suitors and LuxTux accounts are troublesome. They each consume a higher amount of each cost driver than the wholesale customers, and, in particular, they have

a high number of orders a high number of sales visits a high number of regular deliveries a high number of rushed deliveries

Sims needs to consider whether this high level of activity can be reduced without reducing customer revenues.

14-29

3. Customer Distribution Channels Total Wholesale Customers Retail Customers

Total Arvin Madison Total Suitors LuxTux (1) = (2) + (5) (2) = (3) + (4) (3) (4) (5) = (6) + (7) (6) (7)

Revenues (at actual prices) $11,780,400 $7,912,400 $3,754,400 $4,158,000 $3,868,000 $1,936,000 $1,932,000 Customer-level costs 8,996,600 6,020,600 3,010,250a 3,010,350 a 2,976,000 1,519,750 a 1,456,250 a Customer-level operating income 2,783,800 1,891,800 $ 744,150 $1,147,650 892,000 $ 416,250 $ 475,750 Distribution-channel costs 1,480,000 800,000 680,000 Distribution-channel-level operating income 1,303,800 $1,091,800 $ 212,000 Corporate-sustaining costs 600,000 Operating income $ 703,800

a Cost of goods sold + total customer-level operating costs from Requirement 1 4. If Sims allocates all of the $600,000 in corporate costs to the distribution channels as given in the problem, wholesale's channel-level operating income will be $1,091,800 – $330,000 = $761,800 and retail’s channel-level operating income will be $212,000 – $270,000 = –$58,000 (i.e., a loss of $58,000). Since Sims knows that there is no relationship between corporate-sustaining costs and any allocation base, he should not use these new income numbers as the basis of any business decisions. The allocation is arbitrary and only tells him that his retail customers do not cover $270,000 of corporate costs.

14-30

14-30 (40 min.) Customer profitability, distribution.

1. Customer P Q R S T Revenues at list prices

a $29,952 $126,000 $875,520 $457,920 $56,160

Discountb 0 2,100 72,960 15,264 5,616

Revenues (at actual prices) Cost of goods sold

c

Gross margin Customer-level operating costs

29,952 24,960

4,992

123,900 105,000

18,900

802,560 729,600

72,960

442,656 381,600

61,056

50,544 46,800

3,744

Order takingd 1,500 2,500 3,000 2,500 3,000

Customer visitse 160 240 480 160 240

Delivery vehiclesf 280 240 360 640 1,600

Product handlingg 1,040 4,375 30,400 15,900 1,950

Expedited runsh 0 0 0 0 300

Total 2,980 7,355 34,240 19,200 7,090 Customer-level operating income $ 2,012 $ 11,545 $ 38,720 $ 41,856 $ (3,346)

a $14.40 2,080; 8,750; 60,800; 31,800; 3,900 b ($14.40 – $14.40) 50,000; ($14.40 – $14.16) 8,750; ($14.40 – $13.20) 60,800; ($14.40 – $13.92) 31,800; ($14.40 – $12.96) 3,900 c $12 2,080; 8,750; 60,800, 31,800; 3,900 d $100 15; 25; 30; 25; 30 e $80 2; 3; 6; 2; 3 f $2 (10 14); (30 4); (60 3); (40 8); (20 40) g $0.50 2,080; 8,750; 60,800; 31,800; 3,900 h $300 0; 0; 0; 0; 1 Customer S is the most profitable customer, despite having only 52% (31,800 60,800) of the unit volume of Customer R. A major explanation is that Customer R receives a $1.20 discount per case while Customer S receives only a $0.48 discount per case. Customer T is unprofitable, while the smaller customer P is profitable. Customer T receives a $1.44 discount per case, makes more frequent orders, requires more customer visits, and requires more delivery miles than Customer P. 2. Separate reporting of both the list selling price and the actual selling price enables Spring Distribution to examine which customers receive different discounts and how salespeople may differ in the discounts they grant. There is a size pattern in the discounts across the five customers, except for Customer T, larger volume customers get larger discounts: Sales Volume Discount per case R (60,800 cases) $1.20

S (31,800 cases) $0.48 Q (8,750 cases) $0.24 T (3,900 cases) $1.44 P (2,080 cases) $0.00

The reasons for the $1.44 discount for T should be explored.

14-31

3. Dropping customers should be the last resort taken by Spring Distribution. Factors to consider include the following:

a. What is the expected future profitability of each customer? Are the currently unprofitable (T) or low-profit (P) customers likely to be highly profitable in the future?

b. Are there externalities from having some customers, even if they are unprofitable in the short run? For example, some customers have a marquee-value that is “in effect” advertising that benefits the business.

c. What costs are avoidable if one or more customers are dropped? d. Can the relationship with the “problem” customers be restructured so that there is a

“win-win” situation? For example, could Customer T get by with fewer deliveries per month?

14-31 (40 min.) Customer loyalty clubs and profitability analysis. 1.

Gold Program Revenues 2,430 × 20 × ($200 0.90) $ 8,748,000 2,430 × 30 × ($200 0.80) 11,664,000 2,430 × 10 × ($200 0.70) 3,402,000 Total revenues 23,814,000 Variable and champagne costs Hotel variable costs, 2,430 60 $65 9,477,000 Wine and champagne costs 2,430 50 $5 607,500 2,430 10 $20 486,000 Restaurant costs 2,430 20 $10 486,000 2,430 30 $15 1,093,500 2,430 10 $20 486,000 Total variable costs 12,636,000 Contribution margin $11,178,000

14-32

Silver Program Revenues 8,340 20 ($200 0.90) $30,024,000 8,340 15 ($200 0.80) 20,016,000 Total revenues 50,040,000 Variable Costs Hotel variable costs, 8,340 × 35 × $65 18,973,500 Wine costs, 8,340 × 35 × $5 1,459,500 Restaurant Costs 8,340 20 $10 1,668,000 8,340 15 $15 1,876,500 Total variable costs 23,977,500 Contribution margin $26,062,500 Bronze Program Revenues, 80,300 10 ($200 0.90) $144,540,000 Variable costs Hotel variable costs, 80,300 10 $65 52,195,000 Wine costs 80,300 10 $5 4,015,000 Restaurant costs 80,300 10 $10 8,030,000 Total variable costs 64,240,000 Contribution margin $ 80,300,000 No Program Revenues, 219,000 × 1 × $200 $43,800,000 Variable costs, 219,000 × 1 × $65 14,235,000 Contribution margin $29,565,000

Loyalty

Program Total

Revenues Variable

Costs Contribution

Margin Contrib. Margin Total Revenues

Gold $ 23,814,000 $ 12,636,000 $ 11,178,000 46.94% Silver 50,040,000 23,977,500 26,062,500 52.08 Bronze 144,540,000 64,240,000 80,300,000 55.56 No program 43,800,000 14,235,000 29,565,000 67.50 Total $262,194,000 $115,088,500 $147,105,500

The no-program group of customers has the highest contribution margin per revenue dollar. However, it comprises only 16.71% ($43,800,000 $262,194,000) of total revenues. The gold program has the lowest contribution margin per revenue dollar. However, it is misleading to evaluate each program in isolation. A key aim of loyalty programs is to promote a high frequency of return business. The contribution margin to total revenue ratio of each program in isolation does not address this issue.

14-33

2. Revenues $262,194,000 Variable costs 115,088,500 Contribution margin 147,105,500 Fixed costs 140,580,000 Operating income $ 6,525,500

3. Number of room nights

Gold, 2,430 × 60 145,800 Silver, 8,340 × 35 291,900 Bronze, 80,300 × 10 803,000 No program, 219,000 × 1 219,000 1,459,700

Average room rate per night: $262, ,

, ,$179.

194 0001 459 700

62

Average variable cost per night: 84.78$700,459,1

500,088,115$

4. Sherriton Hotels has fixed costs of $140,580,000. A key challenge is to attract a high number of repeat business customers. Loyalty programs aim to have customers return to Sherriton multiple times. Their aim is increasing the revenues beyond what they would be without the program. It is to be expected that the higher the level of nights stayed, the greater the inducements necessary to keep attracting the customer to return. However, given the low level of variable costs to room rates, there is considerable cushion available for Sherriton to offer high inducements for frequent guests.

Sherriton could adopt a net present value analysis of customers who are in the different loyalty clubs. It would be informative for Sherriton to have data on how much of each customer’s total lodging industry expenditures it captures. It may well want to give higher levels

of inducements to frequent guests if the current program attracts only, say, 30% of each of its frequent customer’s total business in cities where it has lodging properties available. On the other hand, there is a cost to Sherriton of giving discounts in its loyalty programs when customers would have chosen to return to Sherriton in any case for other reasons—quality of rooms, quality of service, or quality of restaurants. Sherriton needs to understand how critical lower prices are, relative to other factors, for gaining repeat business.

14-34

14-32 (60 min.) Variance analysis, sales-mix and sales-quantity variances. 1. Actual Contribution Margins

Product

Actual Selling Price

Actual Variable Cost per

Unit

Actual Contribution Margin per

Unit

Actual Sales

Volume in Units

Actual Contribution

Dollars

Actual Contribution

Percent Palm Pro $349 $178 $171 11,000 $ 1,881,000 16% Palm CE 285 92 193 44,000 8,492,000 71% PalmKid 102 73 29 55,000 1,595,000 13% 110,000 $11,968,000 100% The actual average contribution margin per unit is $108.80 ($11,968,000 110,000 units). Budgeted Contribution Margins

Product

Budgeted

Selling Price

Budgeted Variable Cost per

Unit

Budgeted Contribution Margin per

Unit

Budgeted Sales

Volume in Units

Budgeted

Contribution Dollars

Budgeted

Contribution Percent

Palm Pro $379 $182 $197 12,500 $ 2,462,500 19% Palm CE 269 98 171 37,500 6,412,500 49% Palm Kid 149 65 84 50,000 4,200,000 32% 100,000 $13,075,000 100% The budgeted average contribution margin per unit is $130.75 ($13,075,000 100,000 units). 2. Actual Sales Mix

Product

Actual

Sales Volume

in Units

Actual

Sales Mix

Palm Pro 11,000 10.0% (11,000 ÷ 110,000)

Palm CE 44,000 40.0% (44,000 ÷ 110,000)

Palm Kid 55,000 50.0% (55,000 ÷ 110,000)

110,000 100.0%

Budgeted Sales Mix

Product

Budgeted

Sales Volume

in Units

Budgeted

Sales Mix

Palm Pro 12,500 12.5% (12,500 ÷ 100,000)

Palm CE 37,500 37.5% (37,500 ÷ 100,000)

Palm Kid 50,000 50.0% (50,000 ÷ 100,000)

100,000 100.0%

14-35

3. Sales-volume variance:

= Actual Budgeted

quantity of quantity ofunits sold units sold

Budgeted

contribution marginper unit

PalmPro (11,000 12,500) × $197 $ 295,500 U PalmCE (44,000 37,500) × $171 1,111,500 F PalmKid (55,000 50,000) × $ 84 420,000 F Total sales-volume variance $1,236,000 F Sales-mix variance:

= sold products

all of units Actual

×

percentagemix sales

Actual

percentagemix sales

Budgeted ×

unitper margin contrib.

Budgeted

PalmPro = 110,000 × (0.10 0.125) × $197 $541,750 U PalmCE = 110,000 × (0.40 0.375) × $171 470,250 F PalmKid = 110,000 × (0.50 0.50) × $ 84 0 F Total sales-mix variance $ 71,500 U Sales-quantity variance:

=

sold productsall of units Actual

sold products all of units Budgeted

× percentage

mix sales Budgeted

× unitper

margin contrib.Budgeted

PalmPro (110,000 100,000) × 0.125 × $197 $ 246,250 F PalmCE (110,000 100,000) × 0.375 × $171 641,250 F PalmKid (110,000 100,000) × 0.50 × $ 84 420,000 F Total sales-quantity variance $1,307,500 F

14-36

Solution Exhibit 14-32 presents the sales-volume variance, the sales-mix variance, and the sales-quantity variance for Palm Pro, Palm CE, and PalmKid and in total for the third quarter 2007. SOLUTION EXHIBIT 14-32

Sales-Mix and Sales-Quantity Variance Analysis of Aussie Infonautics for the Third Quarter 2007.

Flexible Budget: Static Budget: Actual Units of Actual Units of Budgeted Units of All Products Sold All Products Sold All Products Sold Actual Sales Mix Budgeted Sales Mix Budgeted Sales Mix Budgeted Contribution Budgeted Contribution Budgeted Contribution Margin Per Unit Margin Per Unit Margin Per Unit Palm Pro 110,000 0.10 $197 =$ 2,167,000 110,000 0.125 $197 =$ 2,708,750 100,000 0.125 $197 =$ 2,462,500 PalmCE 110,000 0.40 $171 = 7,524,000 110,000 0.375 $171 = 7,053,750 100,000 0.375 $171 = 6,412,500 PalmKid 110,000 0.50 $ 84 = 4,620,000 110,000 0.50 $ 84 = 4,620,000 100,000 0.50 $ 84 = 4,200,000 $14,311,000 $14,382,500 $13,075,000

$71,500 U $1,307,500 F

Sales-mix variance Sales-quantity variance

$1,236,000 F

Sales-volume variance F = favorable effect on operating income; U= unfavorable effect on operating income 4. The following factors help us understand the differences between actual and budgeted amounts:

The difference in actual versus budgeted contribution margins was $1,107,000 unfavorable ($11,968,000 $13,075,000). However, the contribution margin from the PalmCE exceeded budget by $2,079,500 ($8,492,000 $6,412,500) while the contributions from the PalmPro and the PalmKid were lower than expected and offset this gain. This is attributable to lower unit sales in the case of PalmPro and lower contribution margins in the case of PalmKid.

In percentage terms, the PalmCE accounted for 71% of actual contribution margin versus a planned 49% contribution margin. However, the PalmPro accounted for 16% versus planned 19% and the PalmKid accounted for only 13% versus a planned 32%.

In unit terms (rather than in contribution terms), the PalmKid accounted for 50% of the sales mix as planned. However, the PalmPro accounted for only 10% versus a budgeted 12.5% and the PalmCE accounted for 40% versus a planned 37.5%.

Variance analysis for the PalmPro shows an unfavorable sales-mix variance outweighing a favorable sales-quantity variance and producing an unfavorable sales-volume variance. The drop in sales-mix share was far larger than the gain from an overall greater quantity sold.

The PalmCE gained both from an increase in share of the sales mix as well as from the increase in the overall number of units sold.

The PalmKid maintained sales-mix share at 50%––as a result, the sales-mix variance is zero. However, PalmKid sales gained from the overall increase in units sold.

14-37

Overall, there was a favorable total sales-volume variance. However, the large drop in PalmKid’s contribution margin per unit combined with a decrease in the actual

number of PalmPro units sold as well as a drop in the actual contribution margin per unit below budget, led to the total contribution margin being much lower than budgeted.

Other factors could be discussed here––for example, it seems that the PalmKid did not achieve much success with a three digit price point––selling price was budgeted at $149 but dropped to $102. At the same time, variable costs increased. This could have been due to a marketing push that did not succeed. 14-33 (20 min.) Market-share and market-size variances (continuation of 14-32).

1.

Actual Budgeted Worldwide 500,000 400,000 Aussie Info. 110,000 100,000 Market share 22% 25%

Average contribution margin per unit:

Actual = $108.80 ($11,968,000 110,000) Budgeted = $130.75 ($13,075,000 100,000)

Market-sharevariance =

Actualmarket size

in units

BudgetedActual Budgeted contribution marginmarket market per composite unitshare share for budgeted mix

= 500,000 (0.22 – 0.25) $130.75 = 500,000 (–0.03) $130.75 = $1,961,250 U

Market-sizevariance

= Actual Budgeted

market size market sizein units in units

BudgetedBudgeted contribution marginmarket per composite unitshare for budgeted mix

= (500,000 – 400,000) 0.25 $130.75 = 100,000 0.25 $130.75 = $3,268,750 F

14-38

Solution Exhibit 14-33 presents the market-share variance, the market-size variance, and the sales-quantity variance for the third quarter 2007. SOLUTION EXHIBIT 14-33 Market-Share and Market-Size Variance Analysis of Aussie Infonautics for the Third Quarter 2007.

Static Budget: Actual Market Size Actual Market Size Budgeted Market Size Actual Market Share Budgeted Market Share Budgeted Market Share Budgeted Average Budgeted Average Budgeted Average Contribution Margin Contribution Margin Contribution Margin Per Unit Per Unit Per Unit 500,000 0.22a $130.75b 500,000 0.25c $130.75 b 400,000 0.25c $130.75b $14,382,500 $16,343,750 $13,075,000 $1,961,250 U $3,268,750 F

Market-share variance Market-size variance

$1,307,500 F

Sales-quantity variance

F = favorable effect on operating income; U = unfavorable effect on operating income aActual market share: 110,000 units ÷ 500,000 units = 0.22, or 22% bBudgeted average contribution margin per unit $13,075,000 ÷ 100,000 units = $130.75 per unit cBudgeted market share: 100,000 units ÷ 400,000 units = 0.25, or 25% 2. While the market share declined (from 25% to 22%), the overall increase in the total market size meant a favorable sales-quantity variance:

Sales-Quantity Variance $1,307,500 F

Market-Share Variance Market Size Variance $1,961,250 U $3,268,750 F

14-39

3. The required actual market size is the budgeted market size, i.e., 400,000 units. This can easily be seen by setting up the following equation:

mix budgetedfor unit compositeper

marginon contributiBudgeted

sharemarket

Budgeted

unitsin sizemarket

Budgeted

unitsin sizemarket

Actualvariance

size-Market

= (M – 400,000) × 0.25 × $130.75 When M = 400,000, the market-size variance is $0.

Actual Market-Share Calculation Again, the answer is the budgeted market share, 25%. By definition, this will hold irrespective of the actual market size. This can be seen by setting up the appropriate equation:

Market-sharevariance

=

Actualmarket size

in units

BudgetedActual Budgeted contribution marginmarket market per composite unitshare share for budgeted mix

= Actual market size × (M – 25%) × $130.75 When M = 25%, the market-share variance is $0.

14-40

14-34 (40 min.) Variance analysis, multiple products. 1, 2, and 3. Solution Exhibit 14-34 presents the sales-volume, sales-quantity, and sales-mix variances for each type of cookie and in total for Debbie’s Delight, Inc., in August 2006. The sales-volume variances can also be computed as

Sales-volumevariance = Actual quantity Budgeted quantity

of pounds sold of pounds sold × Budgeted contributionmargin per pound

The sales-volume variances are

Chocolate chip = (57,600 – 45,000) $2.00 = $25,200 F Oatmeal raisin = (18,000 – 25,000) $2.30 = 16,100 U Coconut = (9,600 – 10,000) $2.60 = 1,040 U White chocolate = (13,200 – 5,000) $3.00 = 24,600 F Macadamia nut = (21,600 – 15,000) $3.10 = 20,460 F All cookies $53,120 F

The sales-quantity variance can also be computed as

Sales-volumevariance =

Actual pounds Budgeted poundsof all cookies of all cookies

sold sold

Budgetedsales-mixpercentage

Budgeted

contributionmargin per pound

The sales-quantity variances are

Chocolate chip = (120,000 – 100,000) 0.45 $2.00 = $18,000 F Oatmeal raisin = (120,000 – 100,000) 0.25 $2.30 = 11,500 F Coconut = (120,000 – 100,000) 0.10 $2.60 = 5,200 F White chocolate = (120,000 – 100,000) 0.05 $3.00 = 3,000 F Macadamia nut = (120,000 – 100,000) 0.15 $3.10 = 9,300 F All cookies $47,000 F

The sales-mix variance can also be computed as:

Sales-quantityvariance = Actual sales- Budgeted sales-

mix percentage mix percentage Actual poundsof all cookies

sold

Budgetedcontribution

margin per pound

The sales-mix variances are:

Chocolate chip = (0.48 – 0.45) 120,000 $2.00 = $ 7,200 F Oatmeal raisin = (0.15 – 0.25) 120,000 $2.30 = 27,600 U Coconut = (0.08 – 0.10) 120,000 $2.60 = 6,240 U White chocolate = (0.11 – 0.05) 120,000 $3.00 = 21,600 F Macadamia nut = (0.18 – 0.15) 120,000 $3.10 = 11,160 F All cookies $ 6,120 F

14-41

A summary of the variances is: Sales-Volume Variance

Chocolate chip $25,200 F Oatmeal raisin 16,100 U Coconut 1,040 U White chocolate 24,600 F Macadamia nut 20,460 F All cookies $53,120 F

Sales-Mix Variance Chocolate chip $ 7,200 F Oatmeal raisin 27,600 U Coconut 6,240 U White chocolate 21,600 F Macadamia nut 11,160 F All cookies $ 6,120 F

Sales-Quantity Variance Chocolate chip $18,000 F Oatmeal raisin 11,500 F Coconut 5,200 F White chocolate 3,000 F Macadamia nut 9,300 F All cookies $47,000 F

4. Debbie’s Delight shows a favorable sales-quantity variance because it sold more cookies in total than was budgeted. Together with the higher quantities, Debbie’s also sold more of the high-contribution margin white chocolate and macadamia nut cookies relative to the budgeted mix––as a result, Debbie’s also showed a favorable total sales-mix variance.

14-42

SOLUTION EXHIBIT 14-34 Columnar Presentation of Sales-Volume, Sales-Quantity, and Sales-Mix Variances for Debbie’s Delight, Inc.

Flexible Budget: Actual Pounds of All Cookies Sold

× Actual Sales Mix × Budgeted Contribution

Margin per Pound (1)

Actual Pounds of All Cookies Sold

× Budgeted Sales Mix × Budgeted Contribution

Margin per Pound (2)

Static Budget: Budgeted Pounds of

All Cookies Sold × Budgeted Sales Mix

× Budgeted Contribution Margin per Pound

(3) Panel A: Chocolate Chip

(120,000 × 0.48a) × $2

57,600 × $2

(120,000 × 0.45b) × $2

54,000 × $2

(100,000 × 0.45b) × $2

45,000 × $2 $115,200 $108,000 $90,000 Panel B: Oatmeal Raisin

(120,000 × 0.15c) × $2.30

18,000 × $2.30

(120,000 × 0.25d) × $2.30

30,000 × $2.30

(100,000 × 0.25d) × $2.30

25,000 × $2.30 $41,400 $69,000 $57,500

Panel C: Coconut

(120,000 × 0.08e) × $2.60

9,600 × $2.60

(120,000 × 0.10f) × $2.60

12,000 × $2.60

(100,000 × 0.10f) × $2.60

10,000 × $2.60 $24,960 $31,200 $26,000 F = favorable effect on operating income; U = unfavorable effect on operating income. Actual Sales Mix:

aChocolate Chip = 57,600 ÷ 120,000 = 48% cOatmeal Raisin = 18,000 ÷ 120,000 = 15% eCoconut = 9,600 ÷ 120,000 = 8%

Budgeted Sales Mix: bChocolate Chip = 45,000 ÷ 100,000 = 45% dOatmeal Raisin = 25,000 ÷ 100,000 = 25% f Coconut = 10,000 ÷ 100,000 = 10%

$7,200 F Sales-mix variance

$18,000 F Sales-quantity variance

$25,200 F Sales-volume variance

$27,600 U Sales-mix variance

$11,500 F Sales-quantity variance

$16,100 U Sales-volume variance

$6,240 U Sales-mix variance

$5,200 F Sales-quantity variance

$1,040 U Sales-volume variance

14-43

SOLUTION EXHIBIT 14-34 (Cont’d.) Columnar Presentation of Sales-Volume, Sales-Quantity, and Sales-Mix Variances for Debbie’s Delight, Inc.

Flexible Budget: Actual Pounds of All Cookies Sold

× Actual Sales Mix × Budgeted Contribution

Margin per Pound (1)

Actual Pounds of All Cookies Sold

× Budgeted Sales Mix × Budgeted Contribution

Margin per Pound (2)

Static Budget: Budgeted Pounds of

All Cookies Sold × Budgeted Sales Mix

× Budgeted Contribution Margin per Pound

(3) Panel D: White Chocolate

(120,000 × 0.11g) × $3.00

13,200 × $3.00

(120,000 × 0.05h) × $3.00

6,000 × $3.00

(100,000 × 0.05h) × $3.00

5,000 × $3.00 $39,600 $18,000 $15,000 Panel E: Macadamia Nut

(120,000 × 0.18j) × $3.10

21,600 × $3.10

(120,000 × 0.15k) × $3.10

18,000 × $3.10

(100,000 × 0.15k) × $3.10

15,000 × $3.10 $66,960 $55,800 $46,500

Panel F: $288,120l $282,000m $235,000n All Cookies

F = favorable effect on operating income; U = unfavorable effect on operating income. Actual Sales Mix:

gWhite Chocolate = 13,200 ÷ 120,000 = 11% jMacadamia Nut = 21,600 ÷ 120,000 = 18% l$115,200 + $41,400 + $24,960 + $39,600 + $66,960 = $288,120

Budgeted Sales Mix: hWhite Chocolate = 5,000 ÷ 100,000 = 5% kMacadamia Nut = 15,000 ÷ 100,000 = 15% m$108,000 + $69,000 + $31,200 + $18,000 + $55,800 = $282,000

n$90,000 + $57,500 + $26,000 + $15,000 + $46,500 = $235,000

$21,600 F Sales-mix variance

$3,000 F Sales-quantity variance

$24,600 F Sales-volume variance

$11,160 F Sales-mix variance

$9,300 F Sales-quantity variance

$20,460 F Sales-volume variance

$6,120 F

Total sales-mix variance $47,000 F

Total sales-quantity variance

$53,120 F Total sales-volume variance

14-44

14-35 (15 min.) Market-share and market-size variances (continuation of 14-34). 1.

Actual Budgeted Chicago Market Debbie's Delight Market share

960,000 120,000

0.125

1,000,000 100,000

0.100 The budgeted average contribution margin per unit (also called budgeted contribution margin per composite unit for budgeted mix) is $2.35:

Budgeted Contribution Margin per

Pound

Budgeted

Sales Volume in Pounds

Budgeted

Contribution Margin

Chocolate chip Oatmeal raisin Coconut White chocolate Macadamia nut All cookies

$2.00 2.30 2.60 3.00 3.10

45,000 25,000 10,000 5,000

15,000 100,000

$ 90,000 57,500 26,000 15,000

46,500 $235,000

Budgeted averagecontribution margin per unit =

100,000$235,000 = $2.35

Market-sizevariance incontribution margin

=

Actual

market sizein units

– Budgeted

market sizein units

× Budgeted

marketshare

×

Budgetedaverage

contrib. margin per unit

= (960,000 – 1,000,000) × 0.100 × $2.35 = $9,400 U Market-sharevariance incontribution margin

= Actual

market sizein units

×

Actual

marketshare

– Budgeted

marketshare

×

Budgetedaverage

contrib. marginper unit

= 960,000 × (0.125 – 0.100) × $2.35 = $56,400 F By increasing its actual market share from the 10% budgeted to the actual 12.50%, Debbie’s Delight has a favorable market-share variance of $56,400. There is a smaller offsetting unfavorable market-size variance of $9,400 due to the 40,000 unit decline in the Chicago market (from 1,000,000 budgeted to an actual of 960,000).

14-45

Solution Exhibit 14-35 presents the sales-quantity, market-share, and market-size variances for Debbie’s Delight, Inc., in August 2006. SOLUTION EXHIBIT 14-35 Market-Share and Market-Size Variance Analysis of Debbie’s Delight for August 2006 Static Budget: Actual Market Size Actual Market Size Budgeted Market Size Actual Market Share Budgeted Market Share Budgeted Market Share Budgeted Average Budgeted Average Budgeted Average Contribution Margin Contribution Margin Contribution Margin Per Unit Per Unit Per Unit 960,000 0.125a $2.35b 960,000 0.10c $2.35b 1,000,000 0.10c $2.35b $282,000 $225,600 $235,000 $56,400 F $9,400 U

Market-share variance Market-size variance

$47,000 F

Sales-quantity variance

F = favorable effect on operating income; U = unfavorable effect on operating income aActual market share: 120,000 units ÷ 960,000 units = 0.125, or 12.5% bBudgeted average contribution margin per unit: $235,000 ÷ 1,000,000 units = $2.35 per unit cBudgeted market share: 100,000 units ÷ 1,000,000 units = 0.10, or 10% An overview of Problems 14-34 and 14-35 is: Sales-Volume Variance

$53,120 F

Market-Size Variance $9,400 U

Market-Share Variance $56,400 F

Sales-Mix Variance $6,120 F

Sales-Quantity Variance $47,000 F

14-46

14-36 (20–25 min.) Direct materials efficiency, mix, and yield variances. 1 & 2. Actual total quantity of all inputs used and actual input mix percentages for each input are as follows:

Chemical Actual Quantity Actual Mix Percentage Protex Benz Total

16,200 37,800 54,000

16,200 ÷ 54,000 = 30% 37,800 ÷ 54,000 = 70% 100%

Budgeted total quantity of all inputs allowed and budgeted input mix percentages for each input are as follows:

Chemical Budgeted Quantity Budgeted Mix Percentage Protex Benz Total

20,800 31,200 52,000

20,800 ÷ 52,000 = 40% 31,200 ÷ 52,000 = 60% 100%

Solution Exhibit 14-36 presents the total direct materials efficiency, yield, and mix variances for August 2007. Total direct materials efficiency variance can also be computed as:

Direct materialsefficiency variance

for each input = Actual input Budgeted input quantity

quantity allowed for actual output × Budgetedprice

Protex = (16,200 – 20,800) × $0.40 = $1,840 F Benz = (37,800 – 31,200) × $0.25 = 1,650 U Total direct materials efficiency variance $ 190 F

The total direct materials yield variance can also be computed as the sum of the direct materials yield variances for each input:

Direct materialsyield variancefor each input

= Actual total Budgeted total quantity

quantity of all of all direct materialsdirect materials inputs allowed for

inputs used actual output

×

Budgeteddirect materials

input mixpercentage

×

Budgetedprice of

direct materialsinputs

Protex = (54,000 – 52,000) × 0.40 × $0.40 = 2,000 × 0.40 × $0.40 = $320 U Benz = (54,000 – 52,000) × 0.60 × $0.25 = 2,000 × 0.60 × $0.25 = 300 U Total direct materials yield variance $620 U

14-47

The total direct materials mix variance can also be computed as the sum of the direct materials mix variances for each input:

Directmaterials

mix variancefor each input

= Actual Budgeted

direct materials direct materialsinput mix input mixpercentage percentage

× Actual total

quantity of alldirect materials

inputs used ×

Budgetedprice of

direct materialsinputs

Protex = (0.30 – 0.40) × 54,000 × $0.40 = – 0.10 × 54,000 × $0.40 = $2,160 F Benz = (0.70 – 0.60) × 54,000 × $0.25 = 0.10 × 54,000 × $0.25 = 1,350 U Total direct materials mix variance $ 810 F 3. Energex Company used a larger total quantity of direct materials inputs than budgeted, and so it showed an unfavorable yield variance. The mix variance was favorable because the actual mix contained more of the cheaper input, Benz, and less of the more costly input, Protex, than the budgeted mix. The favorable mix variance offset all of the unfavorable yield variance––

the overall efficiency variance was favorable. Energex Company must also consider the effect on output quality of using the cheaper mix, and the potential consequences for future revenues. SOLUTION EXHIBIT 14-36 Columnar Presentation of Direct Materials Efficiency,Yield and Mix Variances for Energex Company for August 2007

Actual Total Quantity

of All Inputs Used × Actual Input Mix × Budgeted Price

(1)

Actual Total Quantity of All Inputs Used

× Budgeted Input Mix × Budgeted Price

(2)

Flexible Budget: Budgeted Total Quantity of

All Inputs Allowed for Actual Output

× Budgeted Input Mix × Budgeted Price

(3) Protex 54,000 × 0.30 × $0.40 = $ 6,480 Benz 54,000 × 0.70 × $0.25 = 9,450

$15,930

54,000 × 0.40 × $0.40 = $ 8,640 54,000 × 0.60 × $0.25 = 8,100

$16,740

52,000 × 0.40 × $0.40 = $ 8,320 52,000 × 0.60 × $0.25 = 7,800 $16,120

$810 F $620 U Total mix variance Total yield variance $190 F Total efficiency variance F = favorable effect on operating income; U = unfavorable effect on operating income

14-48

14-37 (35 min.) Direct materials price, efficiency, mix and yield variances (Chapter Appendix). 1. Solution Exhibit 14-37A presents the total price variance ($3,240 F), the total efficiency variance ($2,900 U), and the total flexible-budget variance ($340 F). Total direct materials price variance can also be computed as:

Direct materialsprice variancefor each input

= Actual Budgetedprice of input price of input × Actual quantity

of input

Tolman = ($0.35 – $0.40) × 72,000 = $3,600 F Golden Delicious = ($0.29 – $0.30) × 180,000 = 1,800 F Ribston = ($0.22 – $0.20) × 108,000 = 2,160 U Total direct materials price variance $3,240 F

Total direct materials efficiency variance can also be computed as:

Direct materialsefficiency variance

for each input= Actual quantity Budgeted quantity of input

of input allowed for actual output × Budgetedprice of input

Tolman = ( 72,000 – 52,500) × $0.40 = $7,800 U Golden Delicious = (180,000 – 210,000) × $0.30 = 9,000 F Ribston = (108,000 – 87,500) × $0.20 = 4,100 U Total direct materials efficiency variance $2,900 U

SOLUTION EXHIBIT 14-37A Columnar Presentation of Direct Materials Price and Efficiency Variances for Greenwood, Inc., for November 2006. Actual Costs

Incurred (Actual Input Quantity

× Actual Price) (1)

Actual Input Quantity × Budgeted Price

(2)

Flexible Budget (Budgeted Input Quantity Allowed for Actual Output

× Budgeted Price) (3)

Tolman Golden Delicious Ribston

72,000 × $0.35 = $ 25,200 180,000 × $0.29 = 52,200 108,000 × $0.22 = 23,760

$101,160

72,000 × $0.40 = $ 28,800 180,000 × $0.30 = 54,000 108,000 × $0.20 = 21,600 $104,400

52,500 × $0.40 = $ 21,000 210,000 × $0.30 = 63,000 87,500 × $0.20 = 17,500

$101,500

$3,240 F $2,900 U Total price variance Total efficiency variance $340 F Total flexible-budget variance F = favorable effect on operating income; U = unfavorable effect on operating income

14-49

2. Solution Exhibit 14-37B presents the total direct materials yield and mix variances for Greenwood, Inc., for November 2006. The total direct materials yield variance can also be computed as the sum of the direct materials yield variances for each input: Direct

materialsyield variancefor each input

= Actual total Budgeted total quantityquantity of all of all direct materials inputsdirect materials allowed for actual outputinputs used

×

Budgeteddirect materials

input mixpercentage

×

Budgetedprice of

direct materialsinputs

Tolman = (360,000 – 350,000) × 0.15a × $0.40 = 10,000 × 0.15 × $0.40 = $ 600 U Golden Delicious = (360,000 – 350,000) × 0.60b × $0.30 = 10,000 × 0.60 × $0.30 = 1,800 U Ribston = (360,000 – 350,000) × 0.25c × $0.20 = 10,000 × 0.25 × $0.20 = 500 U Total direct materials yield variance $2,900 U

a 52,500 350,000; b 210,000 350,000; c 87,500 350,000 The total direct materials mix variance can also be computed as the sum of the direct materials mix variances for each input:

Directmaterials

mix variancefor each input

= Actual Budgeted

direct materials direct materialsinput mix input mixpercentage percentage

×

Actual totalquantity of all

direct materialsinputs used

×

Budgetedprice of

direct materialsinputs

Tolman = (0.20d – 0.15) × 360,000 × $0.40 = 0.05 × 360,000 × $0.40 = $ 7,200 U Golden Delicious = (0.50e – 0.60) × 360,000 × $0.30 = – 0.10 × 360,000 × $0.30 = 10,800 F Ribston = (0.30f – 0.25) × 360,000 × $0.20 = 0.05 × 360,000 × $0.20 = 3,600 U Total direct materials mix variance $ 0 U

d 72,000 360,000; e 180,000 360,000; f 108,000 360,000 3. Greenwood paid less for Tolman and Golden Delicious apples than budgeted and, so it had a favorable direct materials price variance of $3,240. It also had an unfavorable efficiency variance of $2,900. Greenwood would need to evaluate if these were unrelated events or if the lower price resulted from the purchase of apples of poorer quality that affected efficiency. The net effect in this case from a cost standpoint was favorable––the savings in price being greater than the loss in efficiency. Of course, if the applesauce is of poorer quality, Greenwood must also evaluate the potential effects on current and future revenues that have not been considered in the variances described in requirements 1 and 2. The unfavorable efficiency variance is entirely attributable to an unfavorable yield. The actual mix does deviate from the budgeted mix but at the budgeted prices, the greater quantity of Tolman and Ribston apples used in the actual mix exactly offsets the fewer Golden Delicious apples used. Again, management should evaluate the reasons for the unfavorable yield variance. Is it due to poor quality Tolman and Ribston apples (recall from requirement 1 that these apples were acquired at a price lower than the standard price)? Is it due to the change in mix (recall that the mix used is different from the budgeted mix, even though the mix variance is $0)? Isolating the reasons can lead management to take the necessary corrective actions.

14-50

SOLUTION EXHIBIT 14-37B Columnar Presentation of Direct Materials Yield and Mix Variances for Greenwood, Inc., for November 2006.

Actual Total Quantity

of All Inputs Used × Actual Input Mix × Budgeted Price

(1)

Actual Total Quantity of All Inputs Used

× Budgeted Input Mix × Budgeted Price

(2)

Flexible Budget: Budgeted Total Quantity of

All Inputs Allowed for Actual Output ×

Budgeted Input Mix × Budgeted Price

(3) Tolman 360,000 × 0.20 × $0.40 = $ 28,800 Delicious 360,000 × 0.50 × $0.30 = 54,000 Ribston 360,000 × 0.30 × $0.20 = 21,600

$104,400

360,000 × 0.15 × $0.40 = $ 21,600 360,000 × 0.60 × $0.30 = 64,800 360,000 × 0.25 × $0.20 = 18,000

$104,400

350,000 × 0.15 × $0.40 = $ 21,000 350,000 × 0.60 × $0.30 = 63,000 350,000 × 0.25 × $0.20 = 17,500

$101,500 0 $2,900 U Total mix variance Total yield variance $2,900 U Total efficiency variance

F = favorable effect on operating income; U = unfavorable effect on operating income.

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14-38 (15–20 min.) Customer profitability, responsibility for environmental clean-up, ethics.

1. Customer-profitability analysis examines how individual customers differ in their profitability. The revenues and costs of each customer can be estimated with varying degrees of accuracy. Revenues of IF typically would be known at the time of sale. Many costs also would be known, e.g., the cost of materials used to manufacture the fluids sold to each customer. A major area of uncertainty is future costs associated with obligations arising from the sale. There are several issues here: a. Uncertainty as to the existence and extent of legal liability. Each customer has primary responsibility to dispose of its own toxic waste. However, under some U.S. laws (such as the “Superfund” laws), suppliers to a company may be partially liable for disposal of toxic material. Papandopolis needs to determine the extent of IF’s liability. It would be necessary to seek legal guidance on this issue. b. Uncertainty as to when the liability will occur. The further in the future, the lower the amount of the liability (assuming discounting for the time-value of money.) c. Uncertainty as to the amount of the liability, given that the liability exists and the date of the liability can be identified. Papandopolis faces major difficulties here––see the answer to requirement 2. Many companies argue that uncertainties related to (a), (b), and (c) make the inclusion of “hard-dollar estimates meaningless.” However, at a minimum, a contingent liability should be recognized and included in the internal customer-profitability reports. 2. Papandopolis’ controller may believe that if estimates of future possible legal exposure are sufficiently uncertain, then they should not be recorded. His concern about “smoking guns” may have a very genuine basis––that is, if litigation arises, third parties may misrepresent Papandopolis’ concerns to the detriment of IF. Any written comments that she makes may surface 5 or 10 years later and be interpreted as “widespread knowledge” within IF that they have responsibility for large amounts of environmental clean-up. Given this background, Papandopolis still has the responsibility to prepare a report in an objective and competent way. Moreover, she has visited 10 customer sites and has details as to their toxic-waste handling procedures. If Acme goes bankrupt and they have no liability insurance, one of the “deep pockets” available to meet toxic waste handling costs is likely to be IF. At a minimum, she should report the likely bankruptcy and the existence of IF’s contingent liability for toxic-waste clean-up in her report. Whether she quantifies this contingent liability is a more difficult question. Papandopolis has limited information available to make a meaningful quantification. She is not an employee of Acme Metal and has no information about Acme’s liability insurance. Moreover, she does not know what other parties (such as other suppliers) are also jointly liable to pay Acme's clean-up costs. The appropriate course appears to highlight the contingent liability but to not attempt to quantify it.

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14-39 (40–60 min.) Customer profitability, credit-card operations. 1. Customer A B C D Customer revenues

Annual fee Merchant paymentsa

$ 50

1,600

$ 0 520

$ 50 680

$ 0 160

Interest spreadb 540 0 180 9 Total 2,190 520 910 169

Customer costs Annual maintenance costs Bad debt provisionc Transaction costsd

108 400 400

108 130 260

108 170 136

108

40 100

Customer inquiriese 30 60 40 10 Card replacementsf 0 240 120 0

Total 938 798 574 258 Customer operating income $1,252 $(278) $336 $ (89) a 2% × $80,000; $26,000; $34,000; $8,000 b 9% × $6,000; $0; $2,000; $100 c 0.5% × $80,000; $26,000; $34,000; $8,000 d $0.50 × 800; 520; 272; 200 e $5 × 6; 12; 8; 2 f $120 × 0; 2; 1; 0 Note: The above analysis uses the average 0.5% bad debt provision. Bay Bank may want to adjust individual customer-profitability reports at a subsequent date to reflect actual bad debt experience.

2. Profitable Customers

Unprofitable Customers

Revenues Fees Merchant payments

Interest spread

Pays fee High billings and high billings

per transaction High outstanding balance

Fee waived Low billings and low billings

per transaction Pays on time and has no

outstanding balance Costs

Bad debt “provision” Transaction costs

Customer inquiries Card replacement

Pays account Low number of transactions &

high billings per transaction Zero or few inquiries No replacements

Defaults on account High number of transactions &

low billings per transaction Many inquiries Multiple replacements

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3. The pros of charging for individual services include: a. Additional source of revenues. If Bay Bank is able to charge more than the cost of

each service, it may prefer that customers be prolific users of its services. b. If Bay Bank is not able to charge the “full cost’" for each service, the charge may

reduce customer usage (thus reducing the losses associated with providing services at below cost). For example, Customer B may make fewer inquiries about his or her balance.

The cons of charging for individual services include:

a. May cause customers to drop card or decrease its usage vis-à-vis competitors’ cards

that have zero or minimal charges. b. May attract much negative publicity from consumer groups who target companies such as banks and credit card companies.

4. Factors to consider include:

a. The growth potential of individual customers. Some low-volume credit customers (such as students) may be high-volume users in the medium run.

b. The costs saved by discontinuing low-volume credit card customers. Many costs may be relatively “fixed” and may not be eliminated by dropping customers.

c. The publicity Bay Bank may attract from discontinuing these customers. There is the potential for much negative publicity from such decisions.

d. Alternatives available to discontinuance, e.g., adopt individual service charges. 5. The pros of providing the service at Lucky Roller include:

a. Potential increased profitability due to higher usage by Freedom Card holders at Lucky Roller.

b. Potential increased attraction to current and future Freedom Card holders. As a general rule, the more services available, the more attractive the card.

Possible cons include:

a. Potential bad debts. While money advances in general may have been profitable, it is possible that some specific money advance outlets may be unprofitable. Verdolini should examine this issue in more detail to determine if Bay Bank has made money advances at other gambling venues.

b Potential negative publicity from media stories arguing that the Bay Bank is helping gamblers to lose money. These stories often focus on individuals with gambling addictions.

c. Ethical position of the Bay Bank regarding gambling. Providing a money advance service at the casino may conflict with the ethical beliefs of senior management or the Board of Directors.

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Chapter 14 Video Case

The video case can be discussed using only the case writeup in the chapter. Alternatively, instructors can have students view the videotape of the company that is the subject of the case. The videotape can be obtained by contacting your Prentice Hall representative. The case questions challenge students to apply the concepts learned in the chapter to a specific business situation.

NANTUCKET NECTARS: Cost Allocation

1. The types of economic decisions faced by Nantucket Nectars might include deciding which new juice flavors to introduce to the market, which to discontinue, and how many new flavors the market can absorb. In determining which flavors are most profitable, Nantucket Nectars would need to allocate the costs of the Mobile Juice Guy Team to the different flavors, based perhaps on the time the Mobile Team spends promoting the different flavors and the samples and coupons it distributes. The company may also be interested in determining the profitability of its different regions. To calculate this profitability, the costs of the Mobile Juice Guy Team would need to be allocated to the different regions. The costs of the Mobile Team are: van depreciation, insurance, full-time employee salaries, depreciation of display tables and banners, travel costs (lodging, meals, vehicle gas, and maintenance), coupons, juice beverages, and sample cups. The costs that would go into the fixed- cost subpool are: depreciation on the full-size van, depreciation on the banners and display tables, insurance on the van and equipment, and salaries for the four Mobile Team members. The variable subpool costs would include coupons, bottled juice flavors dispensed, sample cups, and travel expenses for the team. The most appropriate activity base used for allocating the subpool costs would be the time spent in each region, including travel days to the region. 2. Nantucket Nectars could motivate regional sales managers to use more of the Mobile Juice Guy Team by not allocating the full cost of the Team to regional managers. Such a system may, however, lead regional managers to overuse the Mobile Team. 3. Nantucket Nectars would need to cost-justify the Mobile Team’s operations to be sure the

company is getting the necessary sales and profitability boost expected for this set of expenditures. This requires the company to estimate the sales and profitability attributable to the Mobile Team. 4. Although the company is privately held, it still must produce internal financial reports for use by management and external reports for tax purposes. The company also has a majority shareholder, Ocean Spray, for whom reports must be generated. Cost allocation can help with appropriately valuing inventory and assets associated with operations.